CHAPTER 10 EVALUATING PROPOSED CAPITAL EXPENDITURES Table of Contents Section Description Page 1000 INTRODUCTION .......................................................... 10-1 1001 ANALYZING THE CURRENT SITUATION ........................................ 10-2 .2 Using a Diagnostic Approach ............................................. 10-3 .4 Using a Summary Checklist .............................................. 10-3 1002 CAPITAL ASSET PLANNING AND APPROVAL ................................... 10-3 .2 Capital Asset Budgeting ................................................. 10-3 .5 Capital Budget Worksheet. ........................................... 10-4 .6 Requesting Approval for Specific Capital Assets ............................... 10-4 .7 Capital Asset Request Form. .......................................... 10-5 .8 Monitoring Capital Projects ............................................... 10-5 1003 OVERVIEW OF CAPITAL INVESTMENT ANALYSIS METHODS ....................... 10-5 .4 Accounting Rate of Return Method ......................................... 10-6 .8 Payback Method ...................................................... 10-7 .12 Discounted Cash Flow Methods ........................................... 10-7 .14 Net Present Value (NPV) Method. ...................................... 10-8 .19 Internal Rate of Return (IRR) Method. .................................... 10-9 .25 Summary and Recommendation ........................................... 10-10 1004 USING NET PRESENT VALUE TO EVALUATE PROPOSED CAPITAL INVESTMENTS ...... 10-10 .2 Determining the Project's Hurdle Rate ....................................... 10-11 .4 Cost of Capital Component. ........................................... 10-11 .10 Profit Component. .................................................. 10-13 .12 Risk Component. .................................................. 10-13 .15 Worksheet for Computing Hurdle Rate. ................................... 10-14 .16 Estimating Future Cash Flows ............................................ 10-14 .17 Operating Cash Flows. .............................................. 10-14 .18 Other Related Cash Flows. ........................................... 10-15 .19 Worksheet for Summarizing Cash Flows. ................................. 10-16 .20 Computing the Net Present Value of Cash Flows ............................... 10-17 .22 Present Value of Initial Investment. ...................................... 10-17 .23 Computing Present Value When Future Cash Flows Are Even. .................. 10-17 .26 Computing Present Value When Future Cash Flows Are Uneven. ................ 10-18 .30 Discounted Cash Flow Worksheet. ...................................... 10-18 .32 Reaching a Decision on the Proposed Capital Investment ......................... 10-20 1005 USING CAPITAL RATIONING TO RANK ALTERNATIVE CAPITAL PROJECTS ............ 10-21 .3 Using the Profitability Index .............................................. 10-21 1006 REFINING THE CAPITAL INVESTMENT ANALYSIS: MAJOR INVESTMENTS ............. 10-22 .2 Isolating Capital Investment Risks .......................................... 10-22 .3 Sensitivity Analysis. ................................................ 10-22 .9 Breakeven Analysis. ................................................ 10-24 .17 Simple Probability Analysis. ........................................... 10-26 .23 Controlling Capital Investment Risk ......................................... 10-28 .24 Perform More Extensive Analysis and Testing. ............................. 10-28 .25 Shift Fixed Versus Variable Cost Risks. .................................. 10-28 .26 Employ a Staged-Investment Approach. .................................. 10-29 CTS Rel. 11/12 CHAPTER 10 EVALUATING PROPOSED CAPITAL EXPENDITURES Table of Contents (Continued) Section Description Page .27 Modify Pricing Strategy. .............................................. 10-29 .28 Diversify Capital Investments. ......................................... 10-29 .29 Reduce Leverage. ................................................. 10-29 1007 CHOOSING THE FINANCING METHOD: LEASE VS. DEBT .......................... 10-29 .3 Overview of Lease-Versus-Debt Analysis .................................... 10-30 .4 Expected Cash Flows. ............................................... 10-30 .5 Discount Rate. .................................................... 10-30 .6 Lease Terminology. ................................................ 10-30 .7 Example of Lease-Versus-Debt Analysis ..................................... 10-30 .10 Performing Lease-Versus-Debt Analysis ..................................... 10-31 .11 Data Collection. ................................................... 10-31 .12 Tax Classification of Lease. ........................................... 10-33 .14 Analyzing Data. ................................................... 10-33 .15 Making the Final Decision: Subjective Considerations. ........................ 10-34 APPENDIXES 10A Diagnostic Checklist ..................................................... 10-36 10B Summary Checklist ...................................................... 10-38 10C Three-Year Capital Budget Worksheet ........................................ 10-40 10D Capital Asset Request Form ............................................... 10-41 10E Capital Expenditure Status Form ............................................ 10-43 10F Hurdle Rate Worksheet ................................................... 10-45 10G Discounted Cash Flow Worksheet ........................................... 10-47 10H Present Value Tables ..................................................... 10-49 10I Lease-Versus-Debt Data Collection Checklist .................................. 10-52 10J Lease-Versus-Debt Financing Worksheets ..................................... 10-53 CTS Rel. 11/12 10-1 CHAPTER 10 EVALUATING PROPOSED CAPITAL EXPENDITURES ANALYZING THE CURRENT SITUATION CAPITAL ASSET PLANNING AND APPROVAL OVERVIEW OF CAPITAL INVESTMENT ANALYSIS METHODS USING NET PRESENT VALUE TO EVALUATE PROPOSED CAPITAL INVESTMENTS USING CAPITAL RATIONING TO RANK ALTERNATIVE CAPITAL PROJECTS CHOOSING THE FINANCING METHOD: LEASE VS. DEBT 1000 INTRODUCTION 1000.1 Small businesses periodically face various decisions relating to proposed capital expenditures. Those decisions typically include evaluating whether the business should make a specific capital investment, selecting among several capital investment alternatives, and choosing how to finance a proposed investment. Capital investments include both new projects and major extensions of existing projects. Carefully evaluating both the cost-related and qualitative aspects of each proposal usually ensures an appropriate decision. Analysis may also be needed to evaluate proposals for disposing of existing older assets and replacing them with newer assets. In most small businesses, the controller plays a major role in this process, particularly when evaluating an investment's cost-related aspects or validating the revenue generation projections. Nowadays, a company might wish to consider disposing of assets and outsourcing some processes, an alternative that cannot be overlooked in the current business world. 1000.2 Unfortunately, many small business owners make significant capital investment decisions based only on gut reaction or instinct. The decisions can significantly impact the company's future operating results and cash flows because the investments are typically long term. If the business owner considered the investment's financial aspects at only a cursory level or not at all, the business could suffer disastrous results. To reverse such decisions and dispose of acquired assets may involve tremendous costs. The problems a company could face include investments that do not provide sufficient net return due to excess costs relative 1000.2 10-2 CTS Rel. 11/12 to returns and excess unused capacity. Failure to invest in enough capacity could result in lost opportunities to generate profitable revenue. Excessive investments or the failure to replace older, inefficient assets may result in increased product costs. Higher product cost estimates may put pressure on the sales force to raise prices to a noncompetitive level, thereby decreasing sales. This, in turn, could lead to decreased production, resulting in more unused capacity with a consequent increase in product costs. This continuous mounting pressure to increase sales prices as production drops creates a ªdeath spiral.º Controllers should use their influence to safeguard the business by convincing the owner and key managers to incorporate capital investment analysis into the decision-making process. In the event of unused capacities, unused capacity costs should be isolated and not incorporated into the product costs. This amount will show as an added expenditure due to excess capacity, alerting management to tackle the problem of reducing these costs by increasing sales and consequent production, renting out the excess capacity, or disposing of it at a loss. In no case, however, should the cost of unused capacity be passed on to products and recovered through increased sale prices. 1000.3 This chapter provides practical guidance to help controllers perform capital investment analysis for small businesses. It includes the following sections: · Analyzing the Current Situation. Section 1001 presents a simple methodÐusing a diagnostic checklist at Appendix 10AÐfor analyzing the company's existing capital investment evaluation process.